An easy fix for a tricky securities problem

(Fortune) -- A few days ago, I watched one of California's top high school economics teachers lead a class in a discussion of the differences between the earthquakes in Haiti and Chile. I'm applying for my own teaching credential and was there observing.

But when the students focused on building codes, it made me think about my three and one-half years as a lawyer and adviser at the SEC, overseeing the adoption of computer technology to improve financial reporting. In 2004, as the mortgage securities boom approached its peak, the United States had an opportunity to write a building code for: structured financial instruments called asset-backed securities, but that code fell short.

"Although the few comments we received on this point were mixed," the Securities and Exchange Commission wrote in its December 2004 analysis of Regulation AB, "we still do not believe it would be practical or effective to draft detailed disclosure guides for each asset type that may be securitized."

In the SEC's defense, the asset-backed securities market had never experienced a "Big One" like 2008. The SEC sought to formalize decades of practice for the entire ABS industry just as mortgage-backed securities, the most inflated flavor, were reaching their apogee. Political forces were powerfully aligned against stricter codes, and regulators did not know about technology that might help improve asset-backed securities disclosure.

The "builders" -- the sub-prime mortgage industry -- told the SEC stricter codes would inhibit the securitization of home loans required to finance more housing for more homeowners. The "architects" -- big banks and securities firms competing to design and sell mortgage-backed securities -- said standard structural requirements would destroy the beauty of their elegant, unique creations.

Four years after Regulation AB, the 2008 financial crisis made the price of living without codes for mortgage-backed securities transparency painfully obvious.

In contrast, history's most successful building code is U.S. Generally Accepted Accounting Principles. For all its warts, this old-fashioned securities building code works for most public companies and helps make U.S. capital markets the strongest in the world.

Thanks to the structured transparency required by GAAP disclosure, confidence in most public companies during the 2008 crisis could sway without snapping. Public companies and diversified investors generally survived the crisis with property damage but no fatal injuries.

Where GAAP transparency was absent, however, the lack of reliable information -- and in particular, the inability of market participants to use information -- caused confidence to pancake. Uncertainty begat panic on Wall Street. Industry leaders questioned whether there was enough rebar in the edifices they helped create. Fear spread to their brethren in government, some of whom had recently made a living manufacturing and distributing the opaque instruments and others who were convinced by genuine fear that markets were incapable of finding a reasonable equilibrium without government intervention.

Even then, the mortgage-backed securities crisis didn't become a full-fledged securities crisis. Public companies survived unless they were built on foundations made of mortgage-backed securities (like Bear Stearns and Lehman) or were already under stress when exposed to consequences of the panic (like GM).

Pouring a new foundation

The solution to unstructured non-comparable asset-backed securities is to make the securities as transparent as public company securities with structured, comparable, transparent disclosure. Thanks to advances in technology since 2004, such a system is now practical and effective.

In 2007, before the ultimate collapse of the mortgage-backed securities market, hedge funds paid to analyze the securities using structured, standardized, comparable disclosure. Today's solution is to expose the same information to public market scrutiny using the same technology the hedge funds used.

It is not a great leap. In 2008, the SEC required that GAAP facts -- much more complicated than the vast majority of mortgage securities facts -- be reported in a computer language called eXtensible Business Reporting Language, or XBRL. This industry standard language empowers investors to analyze those facts more efficiently.

While we can't expect grandpa to parse every one of the 15,000 or so standard data tags (not to mention custom data tags required for unique company reporting) making this information available to the market as a whole in GAAP format -- even GAAP on paper --proved effective for many decades. That's what market scrutiny is all about.

Asset-backed securities are much less complex than public companies -- at their heart, they simply represent a future flow of funds. But unlike public company securities, they lacked GAAP's structure and transparency, making it more difficult for investors to judge the risk of default than it is to judge the potential of a business to continue to profit.

In paper format, it would have been difficult or impossible to provide such transparency for asset-backed securities. Even today, the SEC's EDGAR system holds thousands of them in ASCII and HTML format, but because there's no common structure, the securities are opaque. You can print them on the paper those standards were designed to emulate, but based on recent experience, the market does not find that information particularly useful.

The challenge of limiting modern financial analysis to the two dimensions of paper is one reason XBRL has become standard building practice, and in many cases a standard building code, for business reporting around the world. It could be the basis for better building codes for any type of investment or security.

The basic principle of securities law that's served the U.S. well since the end of World War II is that if you want the public to invest in your business, you must disclose all the material facts about how you're building your business not just to your investors, but to the entire market, so that the power of market scrutiny can be brought to bear on your business.

You can seek private investment, in which case you're allowed to be less transparent, but these exemptions have been limited so as not to create what we know today as "systemic risk." That is, they were sufficiently limited until the total market capitalization of asset-backed securities began to approach the total market capitalization of all public companies.

Taller buildings need stronger building codes. It can mean the difference between a business cycle and a meltdown.

The good news in finance is that the XBRL technology exists to create strong transparent building codes without imposing the costs and constraints that the builders and architects feared back in 2004. The hedge funds that used XBRL in 2007 proved it was cost effective.

More good news is that SEC Chair Mary Schapiro has directed her staff to take a fresh look at the asset-backed securities building code. If the SEC approaches this project with a combination of the vision it used to implement GAAP in the last century and the understanding that modern transparency requires modern technology, the asset-backed securities market could get back in the fight.

Paul Wilkinson was Senior Adviser to U.S. Securities and Exchange Commission Chairman Christopher Cox from August 2005 until January 2009. He writes at paulwilkinson.com, is an adviser to CLOUD Inc., the Consortium for Local Ownership and Use of Data, and is studying to become a California teacher.